How ETFs Alter the Dynamics of Gold

The forecast for gold prices has recently been in flux, with
2014 appearing more positive than 2013  even before the
military standoff in
Ukraines Crimea region, throwing geopolitics into the
mix. Various factors tend to affect gold prices, including
global security, currencies, interest rates and macroeconomic
outlooks. But forecasters have recently incorporated a new
variable into the equation: retail investors.

Retail gold buyers have for years been associated with
jewelry buyers rather than people seeking bullion as a store of
value, a diversification strategy or an investment tactic. But
small-scale investors
have enjoyed unprecedented access to gold in the past decade
because of
exchange-traded funds backed by the metal itself, rather
than by gold-mining companies or futures. As a result, more
motivations to buy have emerged. The gold ETFs are a
fairly big game changer for the gold industry, with both good
and bad consequences, says Sam Sivarajan, head of
investments at Manulife Private Wealth in Toronto, part of
Manulife Financial Corp. They have democratized gold
buying.

Similar metals-based
ETFs have also affected commodities markets such as those
for silver and platinum. But the SPDR Gold Shares ETF (GLD),
which debuted on the New York Stock Exchange in November 2004
and has traded on NYSE Arca since December 2007, has received
the most attention. GLD, the worlds largest physically
backed gold ETF, has captured roughly 70 percent to 80 percent
of the gold ETF market, says Sivarajan. Last year was the first
annual decline in the gold price since the ETFs
inception. This slump underscored the power of retail
investors over gold prices. Small-scale holders joined
with
hedge funds, which divested about a third of the value of
the gold ETF. That pushed 881 metric tons of the metal onto
global markets, depressing prices.

The ETF fund is marketed by Bostons State Street
Global Markets, an affiliate of State Street Global Advisors.
The fund eliminates logistical hurdles, such as costs of
trading, storing and insuring gold bars, for retail investors
to trade in gold. The price of a share of GLD has ranged from
$127.60 to just under $130 in NYSE Arca trading March 110
and represents the value of one tenth of an ounce of gold.
Storage and trading expenses run about 0.4 percent.

In 2013 the interplay between investors
and gold made it difficult to tell whether ETF sales were a
reaction to gold prices or vice versa. Analysts did not see a
single cause for gold sales last year among those using the
metal as a store of value or a hedge against other portfolio
risks. But once a combination of factors triggered large sales,
low prices may have been a reason for the increased demand by
jewelry buyers, says Martin Murenbeeld, chief economist for
Canadian investment bank Dundee Capital Markets in Vancouver.
Either way, the result was a buying spree elsewhere. Last year
China surpassed India as the worlds largest buyer of gold
jewelry, according to Sivarajan. If demand stays high, however,
prices could jump. If demand in China and elsewhere
remains near record levels but
ETFs stop their selling, the market will be extremely short
of supply, says market research from Germiston, South
Africabased Rand Refinery, the largest integrated
single-site precious metals refining and smelting complex in
the world.

These trades are in the real economy, which is
different than on-paper trades, like futures contracts,
says Francisco Blanch, head of commodities and derivatives
research at Bank of America Merrill Lynch in New York.
For every long in a futures contract, theres a
short, but an ETF backed by the metal alters the specific
supply-and-demand balances.

Also thanks to ETF buyers, demand rose in 2013 for platinum,
a metal for which a supply shortage could pose other economic
questions. Platinum is an integral commodity for carmakers, who
use it in catalytic converters. That is why, some five years
ago, the auto industry lobbied against the creation of
platinum-backed
ETFs out of concern that putting the industry in
competition with investors
for output could boost car prices.

Retail investors
have yet to cause a severe supply drop, but they are likely to
keep buying. The
ETFs are increasingly a staple in portfolios as a means of
diversification and are used by portfolio managers to meet the
demands of their customers. With gold and resources
morphing into their own investment asset class, we expect over
time to see a greater commitment to this, says
Murenbeeld. A parallel can be found in securitized real estate
assets, which despite a degree of infamy gained in the
financial crisis have also proved themselves to be a way to
diversify a basic portfolio dominated by stocks and bonds.

An allocation to international bonds exposes Target Retirement Fund investors to an asset class thats not only influenced by different interest rate and inflation dynamics than U.S. bonds, but which also provides a larger opportunity set of credits.